Stop Losses: Friend or Foe?

Corey Rosenbloom of AfraidToTrade.com added simple stop-loss strategies to his Keltner channel trading system and backtests to see whether it helped our hurt the system.

In the previous research post, I described a simple breakout (or ‘fade’) strategy and revealed the performance metrics on the strategy.

In this post, I wanted to dig a little deeper to see if we could reduce some of the larger losing trades and try to enhance the performance of the strategy by adding a stop-loss exit variable, which was absent in the previous simple test.

Did adding a stop-loss into the system help or hurt overall performance? If so, was the effect small or large (worth it or not?).

You might be very surprised, and yes the effect was large.

Be sure to refresh the data by viewing the earlier post before comparing metrics in the current update.

In the prior update, we saw that net profitability resembled a bell curve with respect to time in a trade (number of days holding a position that triggered).

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We entered long (bought) when price broke and closed above an upper Keltner channel (20-period lookback with two ATR to define bands) in the SPY from 2004 to 2013.

The system returned that the net profitability was best—and relatively stable—from day 14 to 18.

Net profitability was best holding a position for 14 days.

Now, let’s add two types of simple stop-loss strategies to see if we can enhance the net profitability, or specifically reduce the drawdowns.

While I tested 14, 15, 16, and 17 days, I wanted to show (for brevity) the performance metrics for holding an open position 14 days (because this returned the highest net profit).

The first strategy was to use a “fixed dollar trailing” stop-loss, meaning exit the position if price moves down $2.00 from a peak.

If a trigger occurred and price moved $2.00 lower immediately, the position would terminate $2.00 lower.

If price moved up $2.00 and THEN traded down $2.00 (in SPY terms), then the position would terminate with a scratch (no gain/no loss).

And to make the test more robust—meaning I wanted to see the difference in a range of stop-loss variables, not just the arbitrary $2.00 stop loss—ran the strategy 10 times with a dollar trailing stop loss of $1.00 all the way to $10.00.

While the data may reveal something absolutely counter-intuitive, let’s examine the results objectively:

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The reason we run multiple tests is to find a pattern in the data. In other words, we don’t just run a single parameter (example – 10 days in a trade) and expect that outcome to reveal a complete picture.

The “1-10″ stops and targets parameter (far left) means that we ran the same test as in our prior post but this time, each of the ten tests added a fixed dollar trailing stop ($1.00 stop, $2.00 stop, and so on).

What’s the very clear pattern?
The smaller the stop, the WORSE the system (net profit) performed; the larger the stop, the BETTER the system performed.

In fact, the data reveal a linear relationship where the worst metrics are with $1.00, then $2.00, and the best metrics flat-line from $7.00 on to $10.00 (where there is no change).

The fixed/flat-line in the data from $8.00 to $10.00 means that a stop-loss that large was never triggered in the system.

NEXT PAGE: How Did the Stop Loss Affect the System?

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The data speak clearly—this system works best WITHOUT a stop-loss strategy. The tighter the stop, the worse the system performed.

Yes, this goes against conventional wisdom and the psychological comfort of using a stop-loss to prevent a small loss (losing trade) from morphing into a large loss, but remember that the strategy has a built-in stop-loss.

Any and all positions are sold at a fixed number of days after the position is entered—in this case, 14 days regardless of profit and loss.

A caveat—does this mean you should never use stop-losses? No, absolutely not, but within the context of this one simple strategy, stop-losses appeared to degrade performance to the point where the best results emerged from using no (or at least not a fixed dollar trailing) stop loss at all.

Why might this be?
To answer this question—and clear confusion—let’s compare two graphs from trade outcomes.

The first chart shows six triggered trades using the “buy a break and close above the upper Keltner channel” strategy in the SPY during 2013.

In the context of a powerfully rising (impulsive) market, all six trades were profitable (holding 14 bars/days):

The second graph shows a ‘comfortable’ and acceptable $2.00 fixed dollar trailing stop as mentioned above.

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While the first “no stop-loss” chart reveals six profitable trades, the second graph closes a position that falls $2.00 from a recent high (fixed dollar trailing stop) as an attempt to limit losses, particularly on failed trades (false breakouts).